Search frictions make small businesses pay more for health insurance

An article in the American Economic Review finds that small businesses have been over-paying for health insurance.

The article "Unhealthy Insurance Markets: Search Frictions and the Cost and Quality of Health Insurance" highlights the difficulties small employers have in searching for health insurance. The difficulties of comparison shopping increase average health insurance premiums paid by small businesses by 29 percent.

The paper is published in the August 2011 issue of the AER, which is among the most respected scholarly journals in economics.

When James Rebitzer (Boston University School of Management), and research colleagues Mark Votruba and Randall Cebul (both at Case Western Reserve University's Weatherhead School of Management), and Lowell Taylor (Carnegie Mellon University) began taking insurance markets' vital signs a few years ago, one fact particularly captured their attention: small employer groups changed plans very frequently.

This turnover was something of a puzzle. "If markets are competitive, plans of similar value should be offered at similar prices," said Votruba. "It's costly to switch plans, so if employers are switching plans all the time, it suggests that something is impeding competition."

The researchers concluded that they observed a phenomenon economists refer to as "search frictions." The study of search frictions is an important part of the economics of labor markets. Indeed, Peter Diamond, Dale Mortensen, and Christopher Pissarides were awarded the Nobel Prize in Economics last year for their pioneering work in studying the difficulties of job search. This paper is the first to apply these theories to the operation of health insurance markets.

Search frictions arise whenever consumers are unable to easily compare all the options available to them in the marketplace. This, Votruba, Cebul, Rebitzer and Taylor argue, is exactly the case for purchasers of individual and small group health plans.

"Consumers have hundreds, sometimes thousands, of different options, and each plan has its own unique set of benefit details," Votruba said. "In this complex environment, it's hard for consumers to find the plan that offers them the best value. What our paper shows is that this 'shopping problem' has important implications for how market competition plays out. If consumers have a hard time evaluating value, competition becomes less about value, and more about marketing."

A hallmark of markets with search frictions is that the law of one price breaks down. Instead of competition forcing all insurers to offer similar plans at a similar low price, frictions enable many insurers to profitably pursue high margin/low volume strategies. The net effect is that consumers end up paying more for their health insurance - 29 percent more on average in the small group market - and insurers spend more on marketing.

Search frictions also give employers an incentive to change insurers in search of better rates. "High turnover rates undermine the quality of health plans by reducing insurers' incentive to finance care that makes their policyholders healthier in the future," Cebul said. "Why spend money on wellness or disease management programs - programs which yield a return on investment only after several years - for a policyholder who probably isn't going to stick around long?"

If search frictions in health insurance markets cause small businesses to pay too much for low quality policies, can the health insurance exchanges mandated by health care reform law do better? This paper's findings suggest they probably can.

"In theory, they should," said Rebitzer, "as long as they are designed so that shoppers can easily evaluate the value that they should expect for the prices of different plans. We will know that the exchanges are successful if turnover rates and marketing expenses decrease."